Lecture outline Crowding out effect Closed and open economies Ricardian equivalence revisited Debt burden and dead weight loss

Fiscal Crowding out effect The effect of public debt depends on time frame: long run and short run For example, let us assume that the government cut taxes by 5 percent and attracted the debt equal to the sum of lost tax revenue This move will cause 5 percent increase in current disposable income

Fiscal Crowding out effect

Closed economy:

Open economy:

Fiscal crowding out in the liquidity model -interest rate I - investment D- demand for money D + Public debt S- savings I0I0 i0i0 i i1i1 I1I1

Implications of crowding out For example, in the US extra dollar of investment is associated with 9,5 percent growth in GNI. This means that if extra dollar of government bond sold crowds out one dollar of investment, then selling 1 dollar worth bond will cut GNI growth by 9,5 percent. Debt burden will be transferred the future generations because the decrease in investments will lower the future output and the level of income.

Ricardian equivalence revisited Ricardo saw taxes and debt to be the same in their impact on economy. This is because people know that to finance the tax cut the government will attract debt. They also assume that this debt will be paid by increased taxes in the future. Since people are rational and expect taxes to increase in the future they will save extra disposable income due to tax cut. In the end, according to Ricardo, taxes will be equal to debt.

Budget constraints Budget constraints can be divided into two categories:  Hard budget constraint (e.g. market economy)  Soft budget constraint (e.g. planned economy)

Permanent income hypothesis People base their decisions on permanents income, not current one. If current income is below permanent income, people cover their income by attracting deficit. If current income is above permanent income, people use surplus to buy government bonds Debt and bonds are means of smoothing consumption over time

Milton Friedman’s permanent income hypothesis Permanent income is the average of past incomes. Form example, assume that last four year annual income was equal to 1000,2000,3000 and Then permanent income ( )/4=2500 Current income= permanent income + variable income Expected variable income is equal to zero. Consumer expenditures= k* permanent income  where k- marginal propensity to consume

Tax cut does not affect permanent income Assume that the government cuts taxes by 1000 dollar and finances budget deficit by 1000 dollar worth government bond with 10 percent interest. Therefore, every year government should pay 100 dollar interest payments out of taxes. Consumers do not use 1000 dollar for consumption. Instead, they save and get 100 dollar interest payments annually. If the government collects extra 100 dollar taxes to cover this interest rate payment, consumers pay for tax by interest income. In the end, tax cut policy of the government does not change their permanent income and consumption.

Ricardian equivalence -interest rate I - investment D- demand for money D + Public debt S- savings I0I0 i0i0 i I1I1

Barro’s view of Ricardian equivalence Robert Barro in his “Are Government Bonds Net Wealth?” (Journal of Political Economy, 1974) claims that by cutting taxes in Ricardian equivalence the government simply reallocated taxes in time He pointed to generational altruism, which means that even if taxes are increased in future generation, the current generation still saves tax cut funds so that not to leave any burden to the future generation. In this context, the generations form immortal family

Barro’s view of Ricardian equivalence

Problems with Ricardian equivalence Households are not rational Pressing issues such as mortgage and other liabilities Burden to the future generations is difficult to measure Current generation might not be altruistic! Nevertheless, Ricardian equivalence is still useful in interpretation of the consequences of public debt

Distortionary effect of taxation Taxes decrease incentive to invest, production, labor and consumption. High rates of taxation lead to tax evasion practices 98 percent taxes have distortionary effect and cause tax burden Alan Auerbach and James Hines in their “Taxation and Economic Efficiency,” (NBER Working paper 8181, March 2001) point that taxes decrease economic effectiveness know as dead weight loss or excessive tax burden.

Ricardian equivalence -price Q - quantity D- demand S- supply Q0Q0 p0p0 p Consumer surplus Producer surplus

Ricardian equivalence -price Q - quantity D- demand S- supply Q0Q0 p0p0 p Dead weight loss Producer surplus Q1 p1p1 Fair tax burden

Dead weight loss in economies In the US, the dead weight loss is about 20 cents per dollar of government expenditures, in Canada cents (Ballard, Charles, John Shoven and John Walley, “The Total Welfare Cost of the United States Tax System: A General Equilibrium Approach,” National Tax Journal, June 1985) Moreover, if tax rate is doubled, the dead weight loss will quadruple. This is called the “rule of square”

Rule of square -price Q - quantity D- demand S- supply Q0Q0 p0p0 p Dead weight loss Producer surplus Q1 p1p1 Fair tax burden Q2

Summary of debt burden Debt is burden for economy in the form of deadweight loss Public debt differs from private debt by dead weight loss Internal and external public debts have the same dead weight loss. However, in the case of external debt national wealth decreases.

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